Theory of Rational Futures-Style Option Pricing
Universidad Austral; McGill University - Desautels Faculty of Management
Domingo A. Tarzia
Univ. Austral, FCE, Mathematics Department & CONICET
Options on futures traded in Europe, Australia and South Africa are subject to futures-style premium posting (FSPP): the premium is not paid up front but marked to market, and the last settlement premium paid upon exercise. The previous literature has derived pricing models for such options. Only after that derivation, and using the resulting model or its assumptions, has it deducted pricing constraints like a put-call parity or the positivity of time value. Following Merton (1973), we do the reverse. First, we show the full generality of all properties found by Lieu (1990) and many other rational option-pricing constraints. In the second part of the article, we derive a binomial model not found in the literature, and give another derivation of Lieu (1990)’s model. In these derivations, we emphasize, first, the possibility of pricing an option by replicating its mark-to-market cash flows (MTM CF) rather than a final payoff and, second, the irrelevance of the interest rate process, which holds even though futures-style options generate a continuous stream of MTM CF. The irrelevance of interest rates is also true for rational option-pricing constraints.
Number of Pages in PDF File: 36
Keywords: futures-style options, futures Merton Lieu, LIFFE, Europe Sydney Exchange, Safex constraints
JEL Classification: G12, G13working papers series
Date posted: September 10, 2009
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